It’s happened to all of us — we feel on-track with our spending for the month, and all of a sudden an unexpected expense sneaks up and slams us, immediately sending us over-budget.
There’s the wedding gift you forgot to buy, that unlucky parking ticket, or the emergency flight home you booked.
“No matter how hard you try to avoid them, there will always be unexpected expenses,” writes Ramit Sethi in his personal finance book “I Will Teach You To Be Rich.”
There are two types of “disruptive expenses” that can wreck your budget, Sethi writes: known irregular events — such as vehicle registration fees, Christmas gifts, or vacations — and unknown irregular events, such as wedding or baby-shower gifts, late fees, and unpredictable medical expenses.
While it can be tempting to brush these expenses off as too infrequent to account for, it only takes one overdraft fee on your checking account to realise why it’s so important to be prepared.
Everyone spends money differently, but Sethi offers a general “conscious spending plan” that most people can use as a starting point by breaking down spending into four categories:
- Fixed costs such as rent and utilities (50% to 60%)
- Investments such as a Roth IRA or 401(k) plan (10%)
- Guilt-free spending for dining out, drinking, the movies, or clothes (20% to 35%)
- Savings goals for a house down payment, vacation, gifts, or wedding (5% to 10%)
To implement this spending plan, he recommends setting up a checking account and multiple sub-savings accounts. Fixed costs and guilt-free spending will come from your checking account, and contributions to your retirement accounts should come straight from your paycheck. As for savings goals, use sub-savings accounts in order to save for specific purchases. For more on setting up and linking your accounts, and using automatic transfers to manage your money, take a look at this flowchart.
Include known, irregular expenses in “savings goals.” “Under ‘Savings Goals,’ you allocate money toward goals where you have a general idea of how much it will cost,” explains Sethi. “It doesn’t have to be exact, but try to get a rough ballpark figure and then save every month toward that goal.” He gives the example of saving for Christmas gifts: If you know gifts will cost you about $US500, start setting aside $US42 each month in January so you’re fully prepared come December.
Include unknown, surprise expenses in “fixed costs.” His rule of thumb is to add 15% to your estimate of your fixed costs to cover the surprise expenses. It’s helpful to start setting aside $US50 each month for the unknown costs. “You’ll soon realise that this cartoonishly low figure [$US50/month] is not enough,” Sethi writes.”But with some time, you’ll have a better idea of what the figure should actually be and can change the amount accordingly … After about a year or two (remember, think long term), you’ll have a very accurate understanding of how to project. The beginning is the hard part, but it only gets easier.”